This is a blog about interacting systems and how they behave: systems thinking construed broadly. Financial markets and economics; politics; and occasionally physical systems are discussed, with an attempt at focusing on how the rules of the game determine the strategies of participants and the possible outcomes.

(Let's ignore the off B/S stuff for this post and assume that all of the other assets are good.)

The proposal puts the deposits and good assets in the good bank, and calls the difference between assets and liabilities 'capital'. Thus we have for the good bank:

Assets

Liabilities

Good loans

1000

Deposits

1200

Other assets

380

Shareholder's funds

180

Notice that the good bank is well capitalised under this proposal.

The bad bank owns all of the equity in the good bank. For it we have:

Assets

Liabilities

Bad loans

500

Bonds Issued

600

Equity in good bank

180

Shareholder's funds

80

It is fairly likely that the equity holders in the bad bank will be wiped out over time, which is right and proper. If the good bank makes money and declares a dividend, the bad bank will receive that income as it stands. Meanwhile the debt holders of the bad bank now have a claim on a rather worse quality institution, at least at first sight. This is a proposal with rather little moral hazard.

The issue comes when we consider the bad bank's position. It is not capitally adequate, not least because material holdings in credit institutions (i.e. its shareholding in the good bank) is a deduction from equity. One might argue that it does not need a banking license as it is now in run off, but still, it is so leveraged that its management will have to sell some of the equity in the good bank. Does a forced seller of bank equity (albeit good bank equity) really help financial stability?

Also notice that the bad bank would consolidate the good bank from an accounting perspective. Again, to get deconsolidation it would have to sell at least 50% of the good bank's equity.

The proposal in short makes sense from a moral hazard perspective, and transfers the taxpayer's deposit guarantee to a well capitalised institution. But it does force the bad bank to sell its position in the good bank almost at once, and that is a rather worrying side effect.